  # Gross Profit Margin

Learn the Steps to Calculate the Gross Profit Margin  Key Learning Objectives
• What is the formula used to calculate the gross profit margin?
• How might you determine what a “good” gross profit margin is for a specific company?
• What are some of the limitations to the gross profit margin metric?
• What is the difference between the gross profit margin and net profit margin metrics?

## Gross Profit Margin Formula

The gross profit margin, or “gross margin” for short, answers the question of, “How much in gross profits is kept for each dollar of revenue?”

The formula for the gross profit margin is the company’s gross profit divided by the revenue in the matching period. The gross profit is calculated by subtracting direct costs (COGS) from revenue, with direct costs referring to expenses directly tied to the production and delivery of specific goods and/or services (typically variable costs).

The COGS are matched to the associated revenues in the same time period, which is commonly known as the “matching principle” of accounting.

Examples of COGS include the following:

• Direct Labor Costs
• Purchase of Materials (i.e. Inventory)

Typically, the gross profit margin is expressed in percentage form, which can be calculated by multiplying the resulting decimal value from the equation above by 100.

For a given period, the revenue and gross profit of a company will be found directly at the top of the income statement.

For example, if a company has generated \$10 million in revenue with \$3 million in COGS, the gross profit is \$7 million.

Upon dividing the \$7 million in gross profit by the \$10 million in revenue and then multiplying by 100, we arrive at 70% as our gross profit margin. Based on the 70% gross profit margin, we can gather that the company has earned \$0.70 in gross profit for each \$1.00 of revenue.

## Interpreting the Gross Profit Margin

Interpreting a company’s gross margin as either “good” or “bad” depends substantially on the industry in which the company operates. For any comparisons of gross margins to be useful, the companies must operate in the same or similar industry with available historical data dating back several years to get a better sense of the industry norm (and patterns).

For example, software companies have been known for having high gross margins, while clothing retailers have historically exhibited razor-thin gross margins and rely on volume to remain profitable.

Service-based industries also tend to have higher gross margins since the COGS for such businesses are minimal (e.g. consulting firms), whereas capital-intensive companies (e.g. manufacturing, industrials, retail) normally have lower gross margins due to margin erosion from the direct costs related to building up inventory, manufacturing products, etc.

Nevertheless, industries with significant direct costs can still consist of market leaders with consistent profits that retain meaningful market shares (e.g. airlines, transportation, retail).

Higher gross profit margins are usually viewed in a positive light, as the potential for higher operating margins and net profit margins increases. An accurate assessment of the gross profit metric depends, however, on understanding the industry dynamics and company’s current business model.

###### Increasing Gross Profit Margin

Three methods for companies to increase their gross profit margin are:

1. Increase Average Selling Price (ASP) – Requires Pricing Power, Upselling, etc.
2. Purchase Inventory at Lower Prices – Requires Negotiating Leverage with Suppliers (e.g. High Order Volume/Frequency, Bulk Purchases, Branding)
3. Integrate Higher Margin Products/Services – Adding New Products/Services with Higher Gross Margins Could Lead to Improved Customer Retention and Cross-Selling Opportunities

## Gross Profit Margin vs Net Profit Margin

The gross profit margin only accounts for direct costs (i.e. COGS), while the net profit margin accounts for all expenses, including operating expenses and non-operating expenses.

The fact that net income is “levered” (i.e. post-debt) and flows solely to equity holders is one of the primary drawbacks to the net margin metric.

In contrast, the gross profit margin accounts for just one outflow of cash, which is the direct costs associated with the production of revenue.

The gross profit metric tends to be better suited for peer comparisons since there is far lower potential for manipulation via discretionary accounting decisions by management.

The gross profit margin, unlike the net margin, is largely unaffected by financing decisions or discretionary accounting policies such as useful life assumptions for purchases of PP&E or differences in the tax rate.

## Gross Profit Margin Excel Template

Now that we’ve discussed how to calculate the gross profit margin, we can move on to a practice exercise using Excel.   Submitting ...

## Gross Profit Margin Example Calculation

For our example modeling exercise, we’ll be calculating and comparing the gross profit margin of three companies, with each having different revenue and COGS assumptions.

The calculation process is as follows:

1. First, we must take the net revenue and the cost of goods sold (COGS) figures from the income statement.
2. Next, we’ll calculate the gross profit by subtracting COGS from revenue.
3. Lastly, we’ll divide the gross profit of each company by the amount of revenue in the corresponding period to quantify the gross profit margin.

To begin, we’ll start by listing out the revenue and cost of goods sold (COGS) assumptions for each company.

###### Model Assumptions

Income Statement – Company A

• Revenue: \$200m
• Cost of Goods Sold (COGS): –\$80m

Income Statement – Company B

• Revenue: \$200m
• Cost of Goods Sold (COGS): –\$60m

Income Statement – Company C

• Revenue: \$200m
• Cost of Goods Sold (COGS): –\$100m

Using these figures, we can calculate the gross profit for each company by subtracting COGS from revenue.

• Company A – Gross Profit: \$200m – \$80m = \$120m
• Company B – Gross Profit: \$200m – \$60m = \$140m
• Company C – Gross Profit: \$200m – \$100m = \$100m

Next, the gross profit would be divided by revenue to get the gross profit margin.

• Company A – Gross Profit Margin: \$200m ÷ \$120m = 60.0%
• Company B – Gross Profit Margin: \$200m ÷ \$140m = 70.0%
• Company C – Gross Profit Margin: \$200m ÷ \$100m = 50.0% Despite the differences in operating expenses (OpEx), interest expense, and tax rates among these companies, none of these differences are captured in the gross profit margin.

The gross profit margin isolates the profits only after COGS is factored in, which makes the metric more informative for peer group comparisons.

Since COGS were already taken into account, the remaining funds are available to be used to pay operating expenses (OpEx), interest expenses, and taxes.

For instance, the operating profit margin, which accounts for COGS and OpEx, is 20% for Company A, 35% for Company B, and 5% for Company C.

As in the case for all profitability metrics, the gross margin should be used in conjunction with other metrics to fully understand the cost structure and business model of the company.  Inline Feedbacks Learn Financial Modeling Online

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